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REPORT OF THE 2009 SPECIAL REVIEW COMMITTEE ON FINRASEXAMINATION PROGRAM IN LIGHT OF THE STANFORD AND MADOFF
SCHEMES
SEPTEMBER 2009
SPECIAL REVIEW COMMITTEE
Charles A. Bowsher (Chairman)
Ellyn L. Brown
Harvey J. Goldschmid
Joel Seligman
INDUSTRY GOVERNOR ADVISERS OF COUNSELMari Buechner Paul V. GerlachW. Dennis Ferguson Griffith L. GreenG. Donald Steel Dennis C. Hensley
Michael A. NemeroffSIDLEY AUSTIN LLP1501 K Street, NWWashington, DC 20005
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TABLE OF CONTENTS
I. EXECUTIVE SUMMARY .............................................................................................. 1
A. The Stanford Case................................................................................................. 2
B. The Madoff Case ................................................................................................... 4
C. Recommendations ................................................................................................. 6
II. BACKGROUND ON FINRA EXAMINATION PROGRAM...................................... 9
III. EXAMINATIONS OF MEMBER FIRMS INVOLVED IN THESTANFORD AND MADOFF SCANDALS.................................................................. 11
A. The Stanford Case............................................................................................... 12
1. Background ............................................................................................... 12
2. Daniel Arbitration and 2003 Cycle Examination...................................... 13
3. 2003 Anonymous Tip Letter..................................................................... 14
4. Basagoitia Arbitration and Notice of SEC Investigation.......................... 17
5. 2005 Cycle Examination........................................................................... 18
6. Meeting with SEC and the SEC Referral Letter ....................................... 23
7. Conclusion of the 2005 Cycle Examination ............................................. 27
8. 2005 Cause Examination .......................................................................... 28
9. 2007 Cycle Examination........................................................................... 38
10. 2007 Miami Branch Examination and 2009 Unannounced BranchExaminations............................................................................................. 39
B. The Madoff Case ................................................................................................. 46
1. Background ............................................................................................... 46
2. Registration of the Madoff Firm as an Investment Adviser ..................... 50
3. 2007 Cycle Examination........................................................................... 51
4. 2003 and 2005 Cycle Examinations ......................................................... 56
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5. Assessment of the Madoff Firm Examinations......................................... 57
6. Examinations of Cohmad Securities......................................................... 61
IV. OVERVIEW OF FINRAS JURISDICTION .............................................................. 65
V. FINRA ACTIONS SINCE THE STANFORD AND MADOFF SCHEMES ............ 69
VI. RECOMMENDATIONS................................................................................................ 71
1. Jurisdiction............................................................................................................ 71
2. Examination Process and Personnel ..................................................................... 73
3. Coordination with the SEC and Other Regulatory Agencies................................ 75
4. Training of FINRA Personnel............................................................................... 76
5. Plan of Action ....................................................................................................... 76
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I. EXECUTIVE SUMMARY
On April 13, 2009, the Board of Governors (Board) of the Financial Industry
Regulatory Authority, Inc. (FINRA) established a Special Review Committee (Special
Committee)1 to review FINRAs examination program, with particular emphasis on the
examinations of FINRA member firms associated with R. Allen Stanford and Bernard L.
Madoff. The Board was particularly concerned by the significant harm to investors caused by
Stanford and Madoff. Pursuant to a resolution approved by the Board, the Special Committee
was asked to recommend . . . changes in the examination program, where appropriate, to
improve member oversight and FINRAs fraud detection capability, and to consider
managements monitoring [of] compliance with examination program policies.2
The Special Committee, acting through outside counsel, reviewed relevant examination
files from 2003 to 2009 of the principal member firms associated with Stanford and Madoff.
Interviews were conducted with the examiners, supervisors, and managers still employed by
FINRA who were involved in the examinations. In addition, outside counsel interviewed
numerous headquarters staff and senior management to enable the Special Committee to develop
factual findings and recommendations.3
In total, outside counsel conducted 60 interviews of
FINRA staff. Because of ongoing civil and criminal actions involving the Stanford and Madoff
schemes, counsel did not interview persons other than current FINRA employees or obtain
information directly from the implicated firms or from the Securities and Exchange Commission
(SEC).
1 All members of the Special Committee are public governors of FINRA.
2 The Charter of the Special Committee is attached as Appendix A to this report. In making its recommendationsregarding FINRAs examination program, the Special Committee was not asked to comment on personnel matters.
3 The Special Committee solicited the input of FINRA senior executive staff prior to finalizing the recommendationspresented in this report.
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The Ponzi schemes allegedly perpetrated by Stanford and admitted to by Madoff are
striking because of their size and duration.4
Madoffs scheme spanned decades, defrauded
thousands of investors, and caused an estimated $64 billion in investor losses. According to the
SEC, Stanford sold numerous investors approximately $7.2 billion of fraudulent products,
purported to be certificates of deposit (CDs), over at least a decade.
FINRAs examinations of the Madoff and Stanford firms did not uncover these frauds.
The histories of the examinations of these firms present distinct lessons for improving FINRAs
examination program.
A. The Stanford Case
Between 2003 and 2005, the National Association of Securities DealersFINRAs
predecessor entityreceived credible information from at least five different sources claiming
that the Stanford CDs were a potential fraud. The most striking was a July 2005 five-page
referral letter from the SECs Fort Worth office that explained in detail why the purported
investment strategy of the offshore bank could not have produced the consistently high returns
being paid by the CDs. The letter stated that the CD program was a possible fraudulent
scheme and that the returns were too good to be true. According to this letter, as of October
2004, [the Stanford firms] customers held approximately $1.5 billion of CDs. Despite the
existence of this red flag and others described in the body of this report, FINRA did not launch
an investigation of whether the Stanford CD program was a fraud until January 2008.5
By the
time the CD program was shut down by the SEC in February 2009, the alleged amount of
4 Bernard Madoff has confessed and pled guilty. As of the publication of this report, Allen Stanford is contestingthe charges against him.
5 As discussed in the body of the report, FINRAs 2005 cause examination did result in a charge against theStanford firm for advertising violations relating to the CD program and a $10,000 fine.
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investor funds had grown to approximately $7.2 billion. According to the court appointed
receiver in the Stanford matter, the vast majority of these funds will never be recovered.
FINRA missed a number of opportunities to investigate the Stanford firms role in the
CD scheme. First, FINRAs Dallas office staff curtailed a 2005 investigation prompted by the
SEC referral letter because of a concern that the offshore CDs were not securities regulated
under federal securities laws. Facts surrounding the decision not to pursue the fraud
investigation indicate that certain of FINRAs examination staff were then, and may remain,
unsure of the full scope of the organizations investigative authority, are reluctant to pursue
investigations where jurisdiction questions arise, and are not adequately trained to identify
alternate bases of jurisdiction.
Second, although the CD program involved billions of dollars of investor funds, FINRA
procedures, at the time and now, do not set forth criteria for escalation of a matter to senior
management or the use of specially-trained investigators based on the gravity and substance of
the fraud allegations. The Dallas staff did not provide the SEC referral letter to senior
management in Washington, DC, until December 2008.
Third, FINRAs member examination program focuses the majority of member
regulation resources on routine cycle exams. Although SEC-required cycle exams play a role
in ensuring that member firms are adequately capitalized and compliant with regulatory
requirements, they are not an effective means for uncovering complex frauds such as the alleged
CD scheme.
Fourth, FINRAs Dallas staff did not adequately document communications with the
SEC, or discussions within FINRA itself, regarding the CD program. As a result, critical
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decisions regarding the course of examinations were influenced by misunderstandings and
incomplete exchanges of information.
Finally, FINRA did notand still does nothave a centralized database that gives
examiners direct, electronic access to all relevant complaints and referrals associated with a
member firm. As a result, no single FINRA staff member was ever aware of all of the red
flags related to the Stanford firm that are discussed in this report.
The Special Committee recommends that FINRAs examination program should be
revamped to ensure that fraud detection and prevention are core elements. This is particularly
critical when the potential fraud poses risk of significant harm to investors. Allegations of the
magnitude and gravity of those in the Stanford case should be given the highest priority,
immediately escalated to FINRA senior management, and vigorously pursued by well-trained
FINRA staff with all necessary investigative tools and techniques. The Special Committee
agrees with and supports the plan of FINRA senior management to create a dedicated fraud
detection unit. The Special Committee believes the unit should centrally manage fraud cases
involving potentially significant investor losses and ensure that cause exams involving
significant allegations of fraud receive the highest priority in terms of staffing and resources.
B. The Madoff Case
The Madoff case provides a different perspective on FINRAs examination program. In
contrast to the Stanford matter, the Special Committee did not find evidence that FINRA
received any whistleblower complaints regarding the Madoff scheme or that the SEC shared any
concerns or specific allegations about Madoff with FINRA prior to the time when Madoff
admitted his fraud. Indeed, the broker-dealer records provided to FINRA contained no
indication that the Madoff firm was operating an investment advisory business. Madoff
maintained separate bank accounts, cordoned off the investment advisory business to a separate
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floor of his firms office space, and deliberately failed to disclose his investment advisory
activity in broker-dealer forms submitted to FINRA.
In 2006, the SEC caused the Madoff firm to register as an investment adviser and to
submit information on its advisory business to the Investment Adviser Registration Depository
(IARD), a system operated by FINRA pursuant to a contract with the SEC. The Madoff firm
continued to represent to FINRA that it was not involved in investment advisory activity, and
more generallythat it did not maintain any customer accounts. FINRA examiners did not have
direct access to the Madoff firms IARD entries.
In the course of their cycle examinations, FINRA examiners did come across several
facts worthy of inquiry associated with the Madoff scheme that, with the benefit of hindsight,
should have been pursued. Most notably, in the course of examining a related firmCohmad
Securities Corporation6that brought investors into the Madoff Ponzi scheme, FINRA staff
observed records of substantial, recurring payments from the Madoff firm to Cohmad. In
addition, in a 2007 examination of the Madoff firm, FINRA staff uncovered commissions from a
London affiliate that now appear to have served as a money laundering operation for Madoffs
investment advisory business. If FINRAs examiners had fully investigated these transactions, it
is possible that they would have developed suspicions and investigated further regarding
Madoffs business.
In the final analysis, however, the most notable fact about the Madoff case is that
FINRAs ability to effectively examine firms registered as both broker-dealers and investment
advisers would be greatly enhanced if FINRA had jurisdiction to enforce the requirements of the
6 As explained in the report, Cohmad was partially owned by Madoff and was located in the offices of the Madofffirm. On June 22, 2009, the SEC filed a lawsuit against Cohmad accusing it and its principals of participating inBernard L. Madoffs Ponzi scheme by raising billions of dollars from hundreds of investors under a shroud ofsecrecy. Complaint in SEC v. Cohmad Securities Corp. et al., S.D.N.Y. 09 Civ. 5680.
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Investment Advisers Act of 1940 (Investment Advisers Act). This additional jurisdiction
would enable FINRA to be more effective in detecting fraud in both broker-dealers and
investment advisers. In addition, to uncover frauds such as that perpetrated by Madoff, FINRA
must amend and improve its examination process and examiner training. The Madoff case
underscores the need for FINRAs examination program to develop means to verify
independently the data submitted by member firms. At present, cycle exams principally rely on
the representations of member firms, and, thus, are heavily dependent on the honesty and
completeness of the member firms response. The Madoff case also highlights the need to
improve the exchange of information within FINRA and between the SEC and FINRA, including
the sharing of information about potentially fraudulent conduct at member firms. Finally, the
Madoff case demonstrates the need for FINRA to clarify the extent of its jurisdiction, and to
more aggressively exercise that jurisdiction.
C. Recommendations
The issues identified above and further described in this report are the basis for the
recommendations of the Special Committee. The recommendations are described in detail in this
report at pages 71-76. Virtually all of these recommendations will require FINRA management
and the Board to make key decisions on resource allocations. Some of these recommendations
will require action by the SEC or Congress. The most important of these recommendations
include:
FINRA should clarify and expand its jurisdiction to enable it to be more effective in
detecting fraud and protecting investors. FINRA is fundamentally hampered by its lack of
jurisdiction over investment advisory activities. FINRA should proactively seek new jurisdiction
from Congress to regulate activities under the Investment Advisers Act to give it more effective
means to detect future Madoff-like situations. FINRA also should clarify its current jurisdiction
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to regulate member firms and associated persons and more aggressively seek information,
especially where there are indications of fraud. FINRA should expand its jurisdiction to enable it
to obtain information from affiliates of member firms in its enforcement of the Securities
Exchange Act of 1934 and FINRA rules when it believes there is evidence of fraud.
FINRA should restructure its examination program to make fraud detection a core
element. The Special Committee supports FINRA managements plan to create a dedicated
fraud detection unit. Examinations should be prioritized to expedite any investigation involving
potential fraud, serious harm to investors, or continuing serious misconduct. This restructuring
should strengthen the cause examination program and revise the cycle examination program. In
taking these steps to improve its examination program, FINRA will need to make greater use of
personnel with specialized skills and improve its internal exam-related procedures. In particular,
FINRA should improve its documentation of legal and regulatory issues, including its internal
communications and communications with other regulators.
FINRA should improve the technology available to its examination staff, enhancing
systems and access so that examiners are empowered to easily locate and analyze all data and
documents within FINRA regarding a member firm. Such tools could have significantly
improved the staffs ability to grasp the pattern of complaints against Stanford.
FINRA should end its virtual total reliance on data provided by member firms. FINRA
should adopt procedures to test and confirm certain member-provided data against third-party
sources such as independent auditors and non-affiliated banks. FINRA also should cross-check
data provided to FINRA in various submissions by the same firm. Third-party verification and
cross-checking could have provided examiners additional means to uncover the Madoff fraud.
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FINRA should work with the SEC and other regulators to expand FINRAs access to and
use of available data about member firms and their associated persons. Such data sharing will
assist FINRA in obtaining more complete information on those that it regulates. FINRA also
should enhance its training program for the examination staff, focusing on fraud training and
requiring formal continuing education and training.
The Special Committee believes the recommendations above should be implemented by
means of a Plan of Action developed by FINRA management and presented for consideration by
the Board. Management has agreed to present a Plan of Action for approval or ratification at the
December 2009 Board meeting.
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II. BACKGROUND ON FINRA EXAMINATION PROGRAM
FINRA is a non-governmental, self-regulatory organization subject to SEC oversight
under Section 15A of the Securities Exchange Act of 1934 (Exchange Act). It was created in
2007 through the merger of the National Association of Securities Dealers (NASD) and the
member regulation, enforcement, and arbitration functions of New York Stock Exchange
Regulation, Inc. (NYSE). It is responsible for overseeing broker-dealers, who must register
with the SEC and become members of FINRA, and registered representatives, who must pass
examinations demonstrating their knowledge and expertise. As of December 31, 2008, there
were 4,895 broker-dealers and 664,975 registered representatives subject to FINRAs oversight.
FINRA also engages in oversight of various securities markets and facilities. FINRA has
approximately 2,800 employees and operates from Washington, DC, and New York, NY, as well
as from 15 district offices around the nation.
FINRA has an active enforcement program designed to promote compliance with the
Exchange Act and FINRA rules. In each year between 2004 and 2008, FINRA and its
predecessors, NASD and NYSE, expelled an average of 21 firms and banned an average of
433 registered representatives from the industry. In each of these years, FINRA also suspended
396 registered representatives, collected approximately $97.4 million in fines, and obtained
restitution for broker-dealer customers amounting to $105 million on average. In 2008, the
settlement of its auction-rate securities cases returned $1.172 billion to investors. Each year
FINRA receives about 25,000 complaints, tips, and similar items, which are processed by an
organization called Central Review Group-Front End Cause. This organization handles about
20,000 of these items and refers the remaining 5,000 to district offices for processing.
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FINRAs examination program is presently organized into two basic departments:
Member Regulation and Market Regulation. Market Regulation, the smaller of the two
departments, is not considered in this report because its responsibilities are not relevant to the
Stanford and Madoff schemes.
The Member Regulation department is charged with oversight of FINRA member firms
and is subdivided into Sales Practice, Risk Oversight and Operational Regulation (Risk
Oversight), and Shared Services. Sales Practice is the largest of these three groups. It is
charged with the oversight of about 4,800 member firms. It had about 560 examiners and
106 supervisors as of December 31, 2008, located in 15 district offices across the United States.
The examiners are supported by enforcement lawyers also located in the district offices who
report separately to the Enforcement department.
Sales Practice is responsible for conducting onsite examinations of financial operations
and sales practicescalled cycle examsas well as cause exams, which stem from
customer complaints, anonymous tips, referrals from the SEC and other sources. Sales Practice
conducts more that 2,100 cycle exams each year. Sales Practices policy is to complete all cycle
exams each year, although this goal is not always met. Firms are scheduled for cycle
examinations every year, every two years, or every four years based on an annual risk
assessment that incorporates numerous factors. Firms judged to be the most prone to regulatory
concerns are examined each year. Sales Practice district offices also complete about 5,000 cause
examinations each year.
Risk Oversight is responsible for overseeing the financial solvency of approximately
500 of the largest FINRA member firms and those with the most complex operations. For
example, almost all clearing and carrying firms are examined by Risk Oversight. Risk Oversight
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also is assigned large proprietary trading firms with over $100 million in annual revenues. The
Madoff firm was scheduled to be examined by Risk Oversight in March 2009, but this exam was
obviated by Madoffs confession. Most firms examined by Risk Oversight are located in the
New York metropolitan area, and most of the subdivisions 140-person examination staff is
located in its office in New York City.
Shared Services is primarily responsible for planning the annual cycle examination
program and for developing policies that control both cycle and cause examinations. This
includes detailed monitoring and budgeting of examination hours. Shared Services also is
responsible for the quality assurance program, Sales Practice policies, training for Sales Practice
examiners and other staff, and the administration of Member Regulation.
Prior to FINRAs formation in 2006, the member firms associated with Stanford and
Madoff that are discussed in this report were members of NASD. For ease of reference, except
where otherwise noted, this report generally refers to both NASD and FINRA as FINRA.
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III. EXAMINATIONS OF MEMBER FIRMS INVOLVED IN THE STANFORD ANDMADOFF SCANDALS
A. The Stanford Case
1.
Background
According to civil and criminal actions brought in 2009 by the SEC and the United States
Department of Justice, respectively, R. Allen Stanford (Stanford) and his closest associates
have engaged in a massive and long-running fraudulent scheme. Acting through a series of
companies under their control, Stanford and his co-defendants are alleged to have sold financial
products, purported to be CDs, and to have diverted investors funds to illiquid, high-risk
investments. As evidenced by sales brochures provided to FINRA and the SEC, the Stanford
companies issuing and marketing the CDs represented to investors that their money was being
placed in safe and liquid investments. These companies also claimed consistent double digit
rates of return for the purported CDs. According to allegations in the SECs case against
Stanford, the claimed rates of return were virtually impossible under the Stanford banks stated
investment strategy, and were fabricated out of whole cloth by Stanford and his co-defendants.
The defendants allegedly defrauded investors of approximately $7.2 billion.
The purported CDs, issued by Stanford International Bank, Ltd. (the Stanford bank),7
were marketed by, among other entities, Stanford Group Company (the Stanford firm), a
Houston-based company with numerous offices in the United States. The Stanford firm was
established in 1995, registered with the SEC as a broker-dealer, and became a member of
FINRA. As a FINRA member, the Stanford firm was subject to periodic cycle and cause exams.
Because the firms home office is located in Texas, many of these exams were conducted by
7 The Stanford bank was founded in Montserrat and, since 1985, has been based in Antigua and Barbuda(Antigua).
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FINRAs Dallas office.8 Between 2003 and 2008, commissions from the sales of offshore CDs
constituted from 38 to 68 percent of the Stanford firms total revenues reported to FINRA.9
2. Daniel Arbitration and 2003 Cycle Examination
In June 2003, a FINRA arbitration took place between the Stanford firm and Gregory
Daniel, a former employee of the firm. Mr. Daniel alleged that he was wrongfully terminated,
that he was pressured to direct [his] clients[] assets to the off shore bank in Antigua, and that
he was forced to sell proprietary managed money products with no track record, cash inflows or
clear investment objective. The arbitration concluded in a settlement between the parties, but
the arbitrators referred the matter to FINRAs Enforcement department in August 2003 for
investigation of possible rule violations by the firm or, alternately, possible abuse of the
arbitration process by Daniel.
FINRAs Enforcement department, in November 2003, referred the Daniel matter to the
then-Associate Director of the Dallas office, for your review and whatever action you deem
appropriate. According to email records from 2003, the Associate Director informed the
examiners involved in the 2003 cycle exam of the Stanford firm about the allegations raised by
Daniel. When interviewed, however, neither the Associate Director nor the Dallas Director
recalled inquiring about the disposition of the Daniel arbitration referral until 2009, when news
8 FINRAs Dallas office is a long-standing NASD-legacy office. From 1999 to 2003, the office was headed byBernerd Young. In 2003, Young was replaced. The new Dallas Director implemented new procedures to increaseboth productivity and the diligence of examiners. Witnesses noted that Youngs departure and the changesimplemented by the new Director precipitated a significant change in personnel within the Dallas officeapproximately half of the staff, including many examiners and exam managers, resigned their positions shortly afterYoung left. The office remained understaffed for some period of time. Witnesses noted that, by 2005, the staffingsituation stabilized due to new hires and transfers from other FINRA offices.
After serving for a period of time as a securities industry consultant, Young was hired as the Managing Director ofCompliance for the Stanford firm in June 2006, a position he held through 2009. The interviews of current FINRAemployees and review of exam files identified no information to suggest that Youngs presence at the firmcompromised FINRAs subsequent examinations of the firm discussed in this report.
9 These commissions are reported in FINRAs cycle exam reports of the Stanford firm under the heading Solicitorof time deposits in a financial institution.
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of the Stanford scandal broke and the Dallas Director sought to identify all files related to the
firm.
The 2003 cycle exam of the Stanford firm was completed on December 15, 2003. The
exam file contains no indication that Daniel was contacted by anyone on the exam team to
determine what he knew about the CDs, or that FINRA took any action against the firm based on
Daniels allegations. The 2003 exam report indicated that 68 percent of the firms revenues were
generated from commissions from the sale of Stanford bank CDs. The 2003 exam file does not
indicate that any of the examiners questioned the Stanford firm about the fact that it generated
upwards of two thirds of its total revenue from the sale of these CDs.
3. 2003 Anonymous Tip Letter
In September 2003, FINRA received an anonymous letter describing an ongoing fraud
within Stanfords business empire. The author claimed to be an insider. In bold capital font, the
letter stated that Stanford Financial Group, the parent company of the Stanford bank and firm,
IS THE SUBJECT OF A LINGERING CORPORATE FRAUD SCANDAL
PERPETUATED AS A MASSIVE PONZI SCHEME THAT WILL DESTROY THE
LIFE SAVINGS OF MANY, DAMAGE THE REPUTATION OF ALL ASSOCIATED
PARTIES, RIDICULE SECURITIES AND BANKING AUTHORITIES, AND SHAME
THE UNITED STATES OF AMERICA. The letter continues as follows:
The Stanford Financial Group of Houston, Texas has been selling to the people ofthe United States and Latin America, offshore certificates of deposit issued byStanford International Bank, a wholly owned unregulated subsidiary. With themask of a regulated US Corporation and by association with Wall Street giantBear Stearns, investors are led to believe these CDs are absolutely safeinvestments. Not withstanding this promise, investor proceeds are being directedinto speculative investments like stocks, options, futures, currencies, real estate,and unsecured loans.
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For the past seventeen years or so, Stanford International Bank has reported toclients in perfect format and beautifully printed material of the highest quality,consistent high returns on the banks portfolio, with never a down year, regardlessof the volatile nature of the investments. By showing these unbelievable returns,Stanford has justified the expense spent on luxury, lavish styles of management,
high bonuses, and generous contributions to all sorts of causes.
The questionable activities of the bank have been covered up by an apparent cleanoperation of a US Broker-Dealer affiliate with offices in Houston, Miami, andother cities that clears through Bear Stearns Securities Corporation. RegisteredRepresentatives of the firm, as well as many unregistered representatives thatoffice within the B-D, are unreasonably pressured into selling the CDs.Solicitation of these high risk offshore securities occurs from the United Statesand investors are misled about the true nature of the securities.
The offshore bank has never been audited by a large reputable accounting firm,
and Stanford has never shown verifiable portfolio appraisals. The bank portfoliois invested primarily in high risk securities, which is not congruent with the natureof safe CD investments promised to clients.
A copy of the Stanford banks annual financial statement was attached to the letter, which
also described Stanfords close association with Antigua, and referenced certain investigations
and press articles suggesting that Stanford had engaged in bribery and money laundering. The
letter concluded by urging regulators to focus on the real market value of the Stanford banks
investment portfolio, which is believed to be significantly below the banks obligations.
(Emphasis in original.) A carbon copy notation indicated that, in addition to FINRA, copies of
the letter were sent to the SEC, a U.S. Senate Committee, the Office of the Comptroller of the
Currency, and various media outlets.
The anonymous letter was processed by FINRAs Central Review Group-Front End
Cause department in Washington, DC.10 An analyst in that department determined that FINRA
lacked jurisdiction over the matter, and referred the letter to the SEC. When interviewed, the
analyst explained that he had concluded that FINRA lacked jurisdiction because he had been
10 At the time, the department was known simply as Front End Cause.
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instructed, as part of his training, that CDs generally were not securities as defined under the
Exchange Act. In reaching this determination, the analyst did not focus on the offshore nature of
the Stanford banks CD program, nor did he consider alternate bases of FINRA jurisdiction. The
conclusion whether an offshore CD will be considered a security is not self-evident and depends,
in large part, on the specific protections provided by the regulatory system in the jurisdiction in
which the product is issued.11
The analyst wrote a short description of his handling of the matter in FINRAs internal
electronic records database (in 2003, known as MERIT; now known as STAR). The
description notes that Product listed is offshore CDs and Certificates of Deposit and that the
investigation concluded with No Juris[diction]. Referred to SEC, 10/20/2003. This comment
is the only substantive description regarding the Front End Cause investigation that anyone in the
Dallas office would have seen when searching for files related to the Stanford firm in the MERIT
or STAR databases. The MERIT and STAR databases did not contain a copy of the anonymous
insider letter, although staff would have seen a reference to the letter and could have obtained a
copy from the office where the entry was made.12
In her interview, the Dallas Director noted that her staff typically consulted the STAR
database in preparing for an upcoming exam, but that, after seeing an entry finding no
11 For a discussion of the SECs position that the Stanford CD are securities, see pages 24-25 and footnote 52below.
12 STAR is a matter tracking system used by FINRA to track investigations, examinations, alerts, sweeps, reviews,referrals, membership applications, filings, disclosures, tips and complaints. The primary users of STAR are
FINRAs Enforcement, Market Regulation and Member Regulation departments. Advertising and CorporateFinance also track matters in STAR. Departments such as Office of Disciplinary Affairs, Registration andDisclosure and Finance update matters in STAR as well with information relevant to their business practices.
Numerous matter-related data elements are tracked in STAR. These include the following: matter type, staff, sourceor origin, contacts (firms, individuals, registered representatives, entities), securities products, markets, comments,correspondence (including relevant dates), high level allegations, rule violations, milestone or matter dates,dispositions or resolutions, billable entities, disciplinary actions (appeals, decisions, sanctions, fines, undertakings,restitution), information requests to firms as well as responses, time and activities. Those with access to the systemare able to track down related documentation by contacting the person or office that input the relevant information.
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jurisdiction, they likely would not have attempted to retrieve the anonymous letter. According to
email records, no one in the Dallas office saw the letter until May 2009, when it was mentioned
in newspaper articles regarding Stanford. At that time, Dallas staff searched various FINRA
databases and uncovered a copy of the letter.13
4. Basagoitia Arbitration and Notice of SEC Investigation
In December 2004, the Associate Director of the Dallas office received an email from a
FINRA enforcement attorney. The email referenced an arbitration between the Stanford firm
and Leyla Basagoitia, a former Stanford financial adviser based in Texas. The Stanford firm had
terminated Basagoitia and brought the arbitration to recover a balance on an employment
promissory note issued to her. Basagoitia countered by alleging that she was improperly
terminated. The email also indicated that the FINRA enforcement official had received a call
from an SEC attorney from Fort Worth regarding the matter. The email further indicates that the
SEC attorney
is involved in the investigation of the claimant firm (Stanford Group Company)involving, among other things, the firms coercion of representatives to sellAntigua CDsRespondents claim is that she was fired because she refused tosell the CDs without documentation and due diligence. [The SEC attorney]wanted to let [FINRA] know that [the SEC Attorneysic, likely Basagoitia] hasprovided much assistance to the SEC in their investigation and that they believethere is a problem with selling the CDsthat the instruments are and weresecurities, etc.
The Associate Director forwarded the FINRA enforcement attorneys email to the Dallas
Director and to four exam managers in the Dallas office, stating that he was not aware of the
SEC investigation re: Sale of Antigua CDs, and that he would call the SEC unless the Dallas
Director or the managers already knew something about the investigation. When interviewed,
13 The system described in footnote 12 does not give staff direct, electronic access to all regulatory informationrelated to a member firm.
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however, the Associate Director had no recollection of the above email and did not recall calling
the SEC about the matter.14
A March 2005 email from an attorney in the SECs Fort Worth office indicates that the
Associate Director of FINRAs Dallas office was communicating with SEC staff regarding the
Stanford firm. In the email, the SEC attorney wrote: If you have any thoughts about the
suitability issue I raised in connection with Stanford, or ideas about the firm generally, I would
love to hear from you. The Associate Director has no recollection of this email or the
referenced communication with the SEC attorney.
5. 2005 Cycle Examination
FINRA performed its next cycle exam of the Stanford firm in 2005. The exam team
consisted of a lead examiner and three junior examiners. The lead examiner had been with
FINRAs Dallas office since 2000. Each of the junior examiners had less than a year of
experience with FINRA.
For approximately a year leading up to the 2005 cycle exam, the lead examiner had been
assigned as the Stanford firms core examiner. At the time, a core examiner was responsible for
reviewing a firms FOCUS15
reports and its annual audited financial statements. The core
examiner was also FINRAs primary contact with the member firm.
When interviewed, the lead examiner noted that he had developed numerous concerns
about the Stanford firm in his capacity as its core examiner. In particular, he noted that most of
the firms revenues were derived from the sale of CDs issued by the Stanford bank. He also
indicated being troubled by the size of the commissions paid by the bank to the firm for CD
14 Other than an occasional email reference and one reference in an internal memorandum, based on interviews andrecords provided, the Dallas office did not memorialize its communications with the SEC about the Stanford matter.
15 The Financial and Operational Combined Uniform Single (FOCUS) report is a basic financial and operationalreport required of broker-dealers subject to minimum net capital requirements set forth in SEC Rule 15c3-1. Thereport contains figures on capital, earnings, and other financial details.
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referrals. In his experience, commissions typically were not paid for CD referrals, and if a
commission was paid, it was generally no more than $50 per referral. By contrast, the Stanford
bank paid the Stanford firm an annual fee equal to three percent of the deposit sum for every CD
account referred by the firm.
The lead examiner also reported having had concerns about the Stanford firms net
capital position, and he noted that the firm had received periodic capital contributions from
Stanford. He also indicated that, about every two to three months, the firms FOCUS report
generated an exceptionan event caused by data the FOCUS system deems irregular
associated with these capital infusions. The lead examiner further expressed the opinion that the
firm was hemorrhaging money and was being kept afloat with capital contributions. He stated
that he periodically questioned the firms Chief Financial Officer about these capital infusions.
The Chief Financial Officer tried to reassure him by noting that Stanford was a prominent and
wealthy individual, as evidenced by his inclusion in the Forbes 400. The lead examiner never
asked the Stanford firm to provide a personal financial statement from Stanford.16
Finally, when reviewing FINRAs files prior to the 2005 exam, the lead examiner came
across a memorandum from the Texas State Securities Board and a Wall Street Journal article.
The Texas State Securities Board memorandum was written in the mid-1990s and expressed
concern that the high return rates and commissions for CDs made it difficult for the Stanford
bank to make a legitimate profit on the CDs. The Wall Street Journal article reported that
16 Based on representations in the Stanford firms filings with FINRA, R. Allen Stanford was identified to the staffas the firms sole director. In particular, in connection with the capital contributions made to the firm by Stanford,the firm submitted to FINRA corporate resolutions approving the contributions. These resolutions were executed byStanford and identify Stanford as the sole director of the firm, as well as the sole shareholder of a holding companythat owned 100 percent of the Stanford firm. As a director of the firm, Stanford would be deemed to be anassociated person, and FINRA accordingly had jurisdiction over Stanford individually. Thus, the staff could havequestioned Stanford personally about the CD program, including the composition of the banks portfolio and theaccuracy of the marketing materials distributed by the Stanford firm.
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Stanford possessed immense influence in Antigua. The lead examiner indicated that the
Securities Board memorandum and the Wall Street Journal article were not the kinds of items
typically found in a FINRA case file.
The lead examiner represented that he decided to inspect virtually every area of the
Stanford firms business in the 2005 cycle exam, but to give special attention to the CD issue.
He believed that prior examiners had not paid sufficient attention to the CD program. His
supervisoran exam manager in the Dallas officeagreed with this approach. According to the
manager, there were substantial concerns in the Dallas office regarding the Stanford firm and the
CD program in particular. According to the lead examiner, he and his manager decided that it
made sense to take a broad look and see what we reel in.17
While the exam team was preparing for the 2005 cycle exam, an enforcement attorney in
the Dallas office joined the discussion on the CD issue. The enforcement attorney had worked
for the SEC prior to joining FINRA. When interviewed, she indicated that, during her time with
the SEC, she had worked on a matter involving Stanfords CD program. She also reported
working on cases involving brokered CDs, which had tested the bounds of the SECs (and
FINRAs) jurisdiction under the federal securities laws. From the moment she became involved
in discussions regarding the CD aspect of the 2005 Stanford cycle exam, the enforcement
attorney reportedly expressed the view that the Stanford CDs were not securities regulated
under the federal securities laws, and were therefore outside of FINRAs jurisdiction.
As part of the pre-exam process for the 2005 cycle exam, the lead examiner sent the
Stanford firm a questionnaire. In response to a question about underwriting, the firm indicated
that it was offering the CDs under the SECs Regulation D (Reg. D), which exempts securities
17 The manager was one of the individuals who, in late 2004, had received a copy of the email discussing theBasagoitia arbitration and the SECs investigation of the Stanford firm. Prior to the 2005 cycle exam, the managerinformed the lead examiner for the 2005 cycle exam that the SEC was looking into the CD program.
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offered in private placements to specified investors from the registration requirements of the
Securities Act of 1933. The examiner noted that he decided to further investigate the Reg. D
claim during the onsite portion of the exam.
The onsite portion of the cycle exam took place in late April and early May 2005. The
lead examiner focused his time on the CD program, and delegated other portions of the exam to
the junior examiners on the team. He asked the Stanford firm to provide due diligence materials
on the Stanford bank and the CDs. In response, the firm supplied only the banks annual report.
The examiner noted that he was surprised to learn that, according to the annual report,
commercial loans constituted less than five percent of the banks assets. He asked the Stanford
firm about this fact and was told that the banks profits came from trading operations and
investments. Given the advertised rates of return on the CDs, he stated that he found this hard to
believe. Although it might have been possible to make high returns on investments in
developing markets, according to the annual report, the Stanford bank mostly invested in
developed markets. In his interview, the examiner expressed the opinion that, if the Stanford
firm was really making the high return rates on the CDs through investments in developed
markets, then they were smarter than Goldman Sachs.
Junior members of the exam team reviewed certain Stanford customer accounts, but did
not come across any evidence of funds going directly from a customer account at the broker-
dealer to a CD purchase.18 The exam team did not, however, look for evidence that customers of
the Stanford firm were liquidating securities to buy into the CD program; for instance, they did
18 FINRAs 2001 cycle exam report on the Stanford firm indicates that, For existing broker dealer clients, funds arewired by Bear Stearns from the clients brokerage account to [the Stanford bank]. While this is not direct evidencethat customers of the firm were liquidating securities to purchase CDs, it is an issue that should have beeninvestigated. It is unclear whether any of the examiners for the 2005 cycle exam ever reviewed the 2001 exam file.For a description of how the SEC ultimately asserted jurisdiction over the Stanford CDs based, in part, on theargument that Stanford firm customers sold securities in connection with the purchase of CDs, see footnotes 20 and52.
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not cross-check CD purchases with sales of securities by the same customers. Such checks
would have identified customers who sold securities and bought CDs through an intermediary
step such as depositing the proceeds of securities sales in a bank. A showing that the firms
customers were liquidating securities in order to buy into the CD program would have provided
FINRAs staff with jurisdiction19 to proceed against the firm under the antifraud provisions of
the federal securities laws, regardless of whether the CDs themselves constituted securities.20
The lead examiner also looked into the firms claim that the CDs were a Reg. D private
offering. As a general matter, SEC rules prohibit companies from engaging in a general
solicitation for Reg. D offerings. However, the examiner noted that the website of the Stanford
bank contained a significant amount of information about the CDs, including interest rates. He
asked the Stanford firm about this and was told that the firm had no control over the content on
the banks website. The examiner did not believe that the firms lack of control over the bank
excused the apparent violation of the Reg. D restrictions, and requested that the firm provide a
written statement explaining why the banks website was not a general solicitation.21
On June 9, 2005, the Stanford firm responded to the lead examiners concerns, asserting
that [w]e believe that the descriptions of CD Products on the website of Stanford International
19 See footnote 52 below.
20 In late 2008, FINRAs Boca Raton office obtained records during their exam of the Stanford firms Miami officethat indicated that a number of Stanford firm customers sold securities and simultaneously purchased CDs.Similarly, the SECs motion in support of a temporary restraining order against Stanford indicates that FromAugust 2008 through December 2008 alone, approximately 50 [Stanford firm] clients liquidated approximately$10.7 million in stocks, bonds, and other similar securities and invested that money in [the Stanford banks] CDs.
Memorandum In Support of Motion for TRO, Prelim. Injunction and Other Emergency Relief, SEC v. StanfordInternational Bank, Ltd. et al., N.D. Tex. 3:09-cv-0298-N.
21 As referenced in the Stanford firms audited financial statements dating back to at least fiscal year 2003, the firmhad entered into a joint marketing arrangement with the Stanford bank. Specifically, the firms annual auditedfinancial statements indicate that Pursuant to joint marketing agreements, the Company and an affiliated foreignfinancial institution agreed to jointly market and offer fixed income and trust products to their respective customers.In connection therewith, the Company is entitled to referral fees based upon percentages of the referred portfolio asdefined in the respective agreements. It does not appear that FINRA staff confronted the Stanford firm with theexistence of this joint marketing agreement.
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Bank do not constitute a form of general solicitation. This is only general information on the
Bank and its products and no current interest rates are posted on this site. An investor cannot
purchase any CD product via the website. The letter also indicated that the firm did not believe
the CDs to be securities subject to U.S. federal or state laws, and that the firm elected to treat the
CDs as a Reg. D offering because of the possibility that the CD deposits or CD certificates
could be deemed to be securities by US regulatory or judicial authority. The examiner was
not persuaded by the firms assertion that the CDs were not securities; however, he was uncertain
as to whether FINRA could show that they were securities. This issue was not pursued further in
the 2005 cycle exam.
22
6. Meeting with SEC and the SEC Referral Letter
Shortly after the onsite portion of the 2005 cycle exam, on June 21, 2005, the Dallas
Director and Associate Director attended a general meeting at the SECs Fort Worth office. At
that meeting, the SEC Assistant District Administrator informed the Dallas Director that the SEC
was concerned about Stanford but was having difficulty pursuing the matter. The Assistant
District Administrator then told the Dallas Director that the SEC would send FINRA a letter to
see if it could help with the investigation.
When interviewed, the Dallas Director indicated that she was shocked that the SEC
would refer the Stanford case to FINRA. If the SEC, with its subpoena power, was having
problems bringing the case, she said she failed to understand how FINRAwhich does not have
22 There is no indication that the Dallas staff made any formal requests to identify the assets comprising theinvestment portfolio that allegedly supported the performance of the CDs or to interview Stanford firm employeesregarding their knowledge of the CDs or the investment portfolio.
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subpoena powercould be more successful. She did not, however, inform the SEC of these
concerns at the time of the meeting.23
According to email records, in the days after the June meeting, Fort Worth SEC staff and
the Dallas Director and Associate Director participated in at least one, and possibly several,
telephone calls regarding the Stanford CD program. The Dallas Director could not recall
whether she personally participated in the call(s), and noted that it was not unusual for the SEC
to contact her staff directly. The Associate Director had no recollection of the substance of the
call(s).24
On July 21, 2005, an attorney in the SECs Fort Worth office sent a five-page letter to the
Associate Director of FINRAs Dallas office. The letter began by referencing our phone
conversation, and provided further information from [the SECs] October 2004 examination of
Stanford Group Company. The SEC letter also noted that, in the latter part of 2004,
approximately 63 percent of the Stanford firms revenues were derived from the sale of the CDs,
and that the firms customers held approximately $1.5 billion of the CDs as of October 2004.
The SEC letter also indicated that, despite the dependence of its business on the CD sales, the
Stanford firm claims that it keeps no records regarding the portfolios into which [the Stanford
bank] places investor funds and that it can not get this information from [the bank]. . . . [The
Stanford firms] admitted inability to get information from [the bank] about the investments
underlying the CDs suggests that [the firm] may be violating NASD Rule 2310 (Suitability).
The letter went on to indicate that, while the firm and the bank claimed that the
investments offered were CDs, [i]n reality, the offerings are either an investment contract or
23 As discussed further at pages 36 and 65 of this report, FINRA Rule 2010 provides authority for FINRA tosanction member firms and registered representatives for conduct that fails to meet just and equitable principles oftrade, which can involve conduct that does not involve securities.
24 No record of the substance of these calls was maintained by the Dallas office.
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interests in an unregulated investment company. In a footnote, the letter set forth the SECs
legal argument as to why the CDs are securities subject to the federal securities laws:
Neither [the bank] nor [the firm] are entitled to rely upon certain United States
case law that holds that a certificate of deposit is not a security. First, [the bank],which is located in Antigua, does not meet the definition of a bank under Section3 of the Securities Act of 1933 (Securities Act). Certainly [the bank] is notsubject to regulatory oversight in the U.S. Although there are cases that have heldthat CDs issued by foreign banks may not be securities, (Wolfe [sic] v. Banco Nacional de Mexico, 739 F.2d 1458 (1984)) these cases turn on the degree of protection offered by the bank regulatory system of the country of the issuing
bank. . . . It is unlikely that Antiguas bank regulatory structure offers depositors
a degree of protection from loss that corresponds to that which exists in the
United States. In contrast to bank CDs offered by banks in the United States, itappears that funds invested in [the banks] CDs bear a significant risk of loss.
Indeed, one document in [the banks] marketing materials (as discussed below)notes that the investors entire investment is at risk and that [the banks] ability tocontinue to pay back principal and interest is dependent on [the bank] continuingto make consistently profitable investment decisions.
(Emphasis added.)
Another section of the letter, under the heading Possible Fraudulent Scheme, indicated
that [t]he CDs being offered appear too good to be true. The section also chronicled a variety
of concerns associated with the CD program, including the highly unusual three percent annual
concession paid for each CD referral, and the consistently high reported performance of the
Stanford banks investments during periods when most of the markets in which the bank claimed
to invest were down substantially. The section also indicated that the Stanford firm engaged in
sales practices commonly associated with fraudulent schemes, including push[ing] its
[registered representatives] to sell the CDs by engaging in aggressive sales contests, and
possibly terminating representatives for refusing to sell the CDs.
In the final section of the letter, under the heading Possible
Misrepresentations/Omissions, the SEC indicated that it had requested, but was never provided
with, specific information regarding how the Stanford banks funds are invested. The SEC letter
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also noted that the Stanford firm provides U.S. investors with only a limitedand potentially
misleadingdisclosure statement regarding the banks investment portfolio and associated risks,
while foreign investors receive even less information on the risks associated with their
investments.
When interviewed, every member of the Dallas office who was asked about the SEC
letter agreed that it was unlike any letter they had received in the past. Ordinary SEC referrals
bear a referral number, contain little factual information, and begin with the phrase we are
referring the following matter. Despite the absence of this boilerplate language, the Dallas
office staff understood the SEC letter to be a referral.
The leadership of the Dallas office decided to open a cause exam to investigate the
allegations in the SEC referral letter. On August 5, 2005, the Dallas Director wrote to the SECs
Forth Worth office, acknowledging receipt of the SECs letter, and indicating that FINRA had
opened an examination to look into the matter. The August 5, 2005 letter also indicated that
FINRA would notify the SECs Fort Worth office of the outcome of its investigation.
On September 12, 2005, the SECs Fort Worth office sent a request letter to the President
of the Stanford firm. The letter indicated that the SEC staff believed the CDs sold by the firm
to be securities, and outlined a number of areas related to the CD program that required
corrective action by the firm.25 The letter also demanded that the firm halt and correct these
violations, and report in writing how this was to be achieved. The letter expressly instructed that
25 These included misrepresentations and omissions in statements to investors (in violation of SEC Rule 10b-5),excessive commissions (in violation of NASD Rules 2440, 2810, and 2830), failure to establish, maintain, andenforce written supervisory procedures (NASD Rule 3010(b)(1)), failure to conduct periodic reviews of customeraccount activity (NASD Rule 3010(c)), failure to develop and implement an adequate anti-money-launderingprogram (NASD Rule 3011), failure to file Treasury form 90-22.1 (Bank Secrecy Act), and failure to meetcontinuing education requirements (NASD Conduct Rule 1120).
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the firms response be sent not only to the SECs Forth Worth office, but also to FINRAs Dallas
Director.
7. Conclusion of the 2005 Cycle Examination
The lead examiner for the 2005 cycle exam was not assigned to the cause exam triggered
by the SEC referral letter. His manager provided him with a copy of the referral letter, but did
not inform him about the conversations with the SEC that took place at the June meeting or in
any subsequent phone calls. The lead examiner stated that he reviewed the letter quickly in 2005
and believed it to be an exam report. He thought the letter signaled that the SEC had taken
over the CD case, and that it had referred only an advertising case to FINRA. As a result, he
stopped focusing on the CD issues he had identified. He did not discuss his interpretation of the
SEC letter, or his decision to curtail the cycle exams inquiry into the CD program, with his
superiors.
In an interview, the lead examiner was shown a copy of the SEC referral letter. He
indicated that this document was what he had referred to as the SECs exam report. He stated
that his characterization of the SEC letter as an exam report was clearly inaccurate, and agreed
that the letter was a straight SEC referral on the CD issue. He also indicated that he had seen the
September 12, 2005, letter from the SEC to the Stanford firm, and that this letter may have
contributed to forming his opinion that the SEC was pursuing the CD case. He expressed regret
that he had misinterpreted the SEC referral letter to FINRA, and indicated that, in light of his
misinterpretation, he did not do all he could have done on the CD issue.
In January 2006, because of the lead examiners case overload, his exam manager
reassigned responsibility for completing the 2005 cycle exam to another examiner. The lead
examiner transferred his files to the new examiner, after which his involvement in the exam
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ended. The lead examiner never discussed his concerns about the CDs described herein with the
examiner in charge of the 2005 cause exam. The 2005 cycle exam was completed in 2007. The
exam resulted in a fine to the Stanford firm,26 but did not result in any action related to the CD
program.
8. 2005 Cause Examination
The Dallas office initiated a cause exam of the Stanford firm to address the CD issue in
the summer of 2005. The same manager who had supervised the 2005 cycle exam, and had
expressed concerns regarding the CDs, supervised the cause exam. The Dallas Director and
Associate Director received periodic briefings on the progress of the exam. The cause exam was
assigned to a senior examiner in the Dallas office who specialized in cause exams.
The same Dallas office enforcement attorney who had told the lead examiner for the 2005
cycle exam that the Stanford CDs were not securities was involved in the 2005 cause exam from
its early stages. She was shown the SEC referral letter, likely just after the cause exam was
initiated. After learning of the referral, she told the cause examiner and other FINRA staff that
the SEC and other federal agencies, including the Postal Service and the FBI, had been looking
at Stanfords CD program for some time. The enforcement attorney also told the cause examiner
that none of these agencies were able to develop and initiate an enforcement proceeding against
the Stanford firm. As chronicled below, during the cause exam, the enforcement attorney
repeatedly expressed the view that the CDs were notsecurities, and that FINRA therefore lacked
jurisdiction to pursue a suitability case related to the CD program.
Shortly after the Dallas office opened the 2005 cause exam, the cause examiner went to
the SECs Fort Worth office to inspect their case files on Stanford. Among those files, she found
26 As a result of the 2005 cycle exam, the Stanford firm was fined $20,000 for improper check holding, includingchecks related to CD purchases.
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a note, apparently from Leyla Basagoitia to an SEC attorney, chronicling a lack of transparency
and due diligence within the Stanford firm regarding the CD program. The note also explained
that the offshore CDs were being primarily sold to unsophisticated investors in Latin America
who have been led to believe that these investments are of a safe nature because they are being
offered by a subsidiary of a regulated U.S. Corporation. The note surmises that, despite the
extremely high advertised CD rates, the value of the banks assets are well below the value of
its obligations to its clients. If this assumption proves to be true, Stanford has engaged in a very
large Ponzi scheme. The cause examiner incorporated this letter into the exam file, but no
further action appears to have been taken to determine what Basagoitia knew about the CD
program.27
In October 2005, counsel for the Stanford firm sent FINRAs Dallas office a copy of a
letter, which had also been sent to the SECs Fort Worth office, disputing the SECs assertion
that the offshore CDs were securities. The letter cited case law from the Supreme Court
indicating that CDs issued by banks in the United States and insured by the Federal Deposit
Insurance Corporation were not securities for purposes of the federal securities laws.28 The
letter also emphasized two cases from the Ninth Circuit (including Wolf v. Banco Nacional De
27 In August 2005, the NYSE received a letter from Maria Perdomo of Venezuela regarding Stanfords CD program.The Perdomo letter indicates that Stanford had been operating in Venezuela for several years without propersupervision and with sales people that are neither registered in the U.S. nor in Venezuela. The letter also indicatesthat these representatives
offer an offshore product to clients that they are told the product is a Certificate of Deposit of a bank, whenin reality the product is simply a hedge fund. The public does not know in reality what they are investingin, thus are being deceived. This product, I believe if sold in the U.S. must have prospectus, explainingall the risks involved and thoroughly explaining the product itself. . . . This bank, obviously doesnt lendmoney, it just takes money in so they can invest it in many things (bonds, commodities, margin purchasesof stocks, etc, etc) all this happening without the client knowing the scope of their supposed certificate ofdeposit.
NYSE forwarded the letter to FINRA. Ultimately, the Perdomo letter was incorporated into the 2005 cause exam.It does not appear that anyone associated with the exam followed up on the allegations raised in the letter.
28Marine Bank v. Weaver, 455 U.S. 551 (1982).
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Mexico,29 which were discussed in the SEC referral letter). These cases held that certain CDs
issued in Mexico were not securities, despite the fact that the Mexican government only provided
deposit holders with priority claim statusand not actual insuranceif the issuing bank became
insolvent. The Ninth Circuit cases concluded that, despite this limitation, the availability of bank
regulation in Mexico and that nations history of successful banks rendered the CD investments
virtually guaranteed. The Ninth Circuit also declined to address a claim that Mexican authorities
were not enforcing Mexican bank regulations, citing the traditional respect paid to foreign
governments by U.S. courts.
In the letter, Stanfords counsel argued that Antigua, like Mexico, provided CD holders
with priority claim status. Stanfords counsel also argued that the Stanford bank was subject to
comprehensive regulation in Antigua, and that U.S. courts were bound to show respect to this
regulatory system.30
Although the examiner assigned to the 2005 cause exam was not an attorney, she
assumed responsibility at the district level to assess the strength of the SECs claim that the CDs
were securities and the Stanford firms response to the contrary. She was assisted in this task by
a paralegal. It does not appear that the cause examiner or the paralegal consulted any case law
concerning offshore CDs other than the cases referenced in the SEC referral letter and the
Stanford firms response.31 Although the question whether the CDs were securities was
29 739 F.2d 1458 (9th Cir. 1984). The other Ninth Circuit case cited by the Stanford firms counsel is West v.Multibanco Comerex, S.A., 807 F.2d 820 (9th Cir. 1987).
30 The Stanford banks CD program differed in several respects from CDs issued by federally regulated banks in theUnited States. First, in contrast to the insurance provided in the United States by the Federal Deposit InsuranceCorporation, the Antiguan government does not guarantee any portion of the CD deposits or interest. Second, incontrast to most U.S. banks, the Stanford bank did not engage in much commercial lending, which might havebrought an increased measure of stability to the CD program.
31 The only other case consulted by the cause examinerGary Plastic Packaging Corp. v. Merrill Lynch, Pierce,Fenner & Smith, 756 F.2d 230 (2d Cir. 1985)involved brokered CDs issued in the United States. This case doesnot appear to have any bearing on the question of whether offshore CDs issued by a bank in Antigua are securities,but the cause examiner found it to be significant. In general, a brokered CD refers to the practice of a broker
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ultimately referred to Sales Practice Policy and the Office of General Counsel, no comprehensive
legal analysis of the issue was ever conducted.32
The cause examiner stated that, based on her review of these materials, she was unable to
conclude that the Stanford bank CDs were securities under the federal securities laws. The
Dallas enforcement attorney involved in the 2005 cause exam agreed with this assessment. In
her interview, the enforcement attorney explained that, earlier in her career, she had come across
the securities issue in the context of brokered CDs. She recalled that the SEC and FINRA had
only prevailed on the securities element in cases where brokered CDs were sold to the public
through fractional interests. The CDs marketed by the Stanford firm were not fractionalized.
When interviewed, neither the enforcement attorney nor other staff involved in the 2005
cause exam could explain why the brokered CD analysis was determinative of the question
whether the offshore Stanford CDs were securities. According to the enforcement attorney, the
brokered CD cases showed that regulatory agencies did not always prevail in arguing that CDs
were securities. The enforcement attorney explained that her job was to serve as a gatekeeper
to prevent cases from moving forward to the enforcement stage unless they truly warranted
formal action. She also indicated that, in her experience, Ponzi schemes do not last as long as
ten years, and that the fact that the Stanford bank had been selling the CDs for such a long period
of time gave the CD program some measure of credibility.33
purchasing CDs from banks and reselling them to the public. The SEC and FINRA were concerned with thepractice because investors did not necessarily purchase the CD itself, and often bought a fractional interest in thepackage of CDs held by the broker.
32 See below at pages 33-35.
33 In her interview, the enforcement attorney claimed that she considered the offshore element as part of her analysisof the issue, and that she bore suspicions regarding the regulatory regimes in certain Caribbean nations. However,there is no indication that she ever discussed these concerns with anyone involved in the 2005 cause exam; rather,all participants in the staff discussion regarding the cause exam recall that their analysis relied on the brokered CDcase law. The enforcement attorney also does not appear to have created any documentation regarding her legalanalysis of the CD issue in connection with the 2005 cycle or the 2005 cause exam.
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In January 2006, the cause examiner referred a portion of the exam to FINRAs
advertising regulation staff. The advertising regulation staff found a number of deficiencies with
the Stanford firms sales brochures, including insufficient warnings about the principal risks to
U.S. investors and the absence of FDIC insurance for the CD program.
According to email records, the cause examiner also conferred with the lead examiner on
the 2005 cycle exam regarding the CDs. Specifically, in February 2006, she emailed him to ask
whether he had any information about what customers were liquidating to purchase Stanford
CDs from your routine exam? The lead cycle examiner responded that he recall[ed] that most
of the trades that we looked at involved new clients who bought the CDs using cash, and they did
not cash out other products or securities positions. When interviewed, the lead cycle examiner
acknowledged that his response was not entirely accurate, as he failed to note that the 2005 cycle
exam team did not check to see if CD purchases were being indirectly funded with proceeds
from liquidated securities.
The cause examiner and the enforcement attorney discussed the securities issue at
several meetings with other staff in the Dallas office, including with the Dallas Director and
Associate Director. The Dallas Director recalls that the discussions focused on the brokered CD
analysis. The discussions culminated in the preparation of an investigative conference report on
the 2005 cause exam in April 2006.34 The cause examiner drafted the report, but failed to
include the fact that, according to the SECs July 2005 referral letter, $1.5 billion in investor
funds were potentially at risk. The reports jurisdiction analysis simply excerpted portions of the
SEC referral letter and the Stanford firms response to the SEC. The conference reports
34 The investigative conference is a required element of every potential formal disciplinary matter. According toFINRAs Member Regulation Handbook, the primary goal of the conference is to enable Enforcement and MemberRegulation to reach consensus on the key aspects of an investigation, including issues, appropriate scope, andrequired evidence about the appropriate treatment of each matter.
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discussion of the state of banking regulation in Antigua quotes from, and is based in significant
part on, the representations of Stanfords counsel. The report concluded that, Based on past
cases and the documented protections that are offered by Antigua, the staff does not believe
[FINRA] can adequately prove that the CDs are securities. This conclusion is debatable. As
described below at footnote 52, the SEC in its case against Stanford reiterated its argument that
the Stanford CDs are securities.
The conference report also described the advertising portion of the cause exam, noting
that Antiguan law does not in fact provide true priority claim status for CD holders, and
described the protections offered by Antiguan law as limited. Specifically, the advertising
section indicates that Antiguan corporate law gives the payment of wind-up costs, the payment
of officers and employees for up to three months prior to the seizure of the bank; all taxes due;
and the fees and assessments owing to the appropriate officer priority over any portion of time
deposit funds. In addition, the advertising section indicates that time deposit holders are only
given preference over other creditors for up to $20,000 in deposit funds.35
In May 2006, the Dallas Associate Director forwarded the conference report to an
attorney in FINRAs Sales Practice Policy group of the Member Regulation department in
Washington, DC.36 The Sales Practice Policy attorney had only been in that position since
January 2006. When interviewed, she indicated that her job was to field legal questions from
district offices, but that this role overlapped with the function of FINRAs Office of General
Counsel, and that only the Office of General Counsel was authorized to develop the
35 The conference report ultimately identified three potential violations of FINRAs advertising rules: (1) thebrochures failed to contain the name of the Stanford firm and failed to make clear the firms relationship with thebank; (2) the brochures failed to present a fair and balanced treatment of the risks and potential benefits of the CDprogram; and (3) the brochures claimed, inconsistent with the assertions made by the firm to FINRA, that the bankwas not subject to the reporting requirements of any jurisdiction and that CD holders were not entitled to depositorprotection.
36 At the time, the group was known as Regulation Policy.
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organizations position on legal issues. Sales Practice Policy did not then and does not now have
an internal handbook to guide its staff in fielding inquiries from district offices.
The Sales Practice Policy attorney was asked to review the conference reports
conclusion that the staff does not believe [FINRA] can adequately prove that the CDs are
securities. She called an attorney in the Office of General Counsel to discuss the issue. During
this call, which reportedly lasted about five minutes, the Office of General Counsel attorney
indicated that CDs are typically not considered securities. The Sales Practice Policy attorney did
not provide a copy of the conference report or inform the Office of General Counsel attorney that
the CDs in question were issued by an offshore bank. Because the conference report did not
reference $1.5 billion in potentially at-risk investor funds, neither attorney was aware of the
magnitude of the potential fraud. In an interview, the attorney from the Office of General
Counsel stated that she found it hard to believe that neither the Dallas office nor Sales Practice
Policy perceived the foreign element of the CDs as the key issue in determining whether the CDs
were securities. When presented with the conference report and the SEC referral letter for the
first time in her interview, the Office of General Counsel attorney indicated that, had she known
the facts outlined therein, she would have focused the securities inquiry on the degree of
protection offered by the Antiguan regulatory system, and that her conversation with the Sales
Practice Policy attorney would surely have lasted more that five minutes.37
After the phone call described above, the Sales Practice Policy attorney recalls that she
contacted the Dallas office and indicated that she and the Office of General Counsel attorney
were unable to confirm that the Stanford bank CDs were securities. In June 2006, the Dallas
Associate Director sent an email to the Dallas Director and other office staff indicating that Sales
37 Neither attorney documented their communications with each other, nor did they create any written recordmemorializing what, if any, legal analysis they conducted.
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Practice Policy and the Office of General Counsel agreed with the staffs assessment of the
securities issue.
Meanwhile, in June 2006, Bernerd Youngthe former head of FINRAs Dallas office
who had left in 2003joined the Stanford firm as Managing Director of Compliance. The
Dallas staff did not consider Youngs presence to have compromised the 2005 cause exam.
In 2006 and 2007, while the cause exam was still ongoing, the manager overseeing the
exam attended several general meetings with the SECs Fort Worth office.38
At one of these
meetings, he informed the SEC that FINRAs enforcement staff could not endorse the
proposition that the CDs were securities. According to the manager, the SEC staff questioned
whether FINRA could bring anything more than an advertising charge.39
During interviews, the Dallas staff were questioned repeatedly regarding the conclusion
that the CDs were not securities. The Director, the Associate Director, and the manager who
oversaw the cause exam expressed reliance on the opinion of the enforcement attorney, as well
as the confirmation by Sales Practice Policy and the Office of General Counsel. The
enforcement attorney expressed the view that, even in 2009, she is not sure that the Stanford
banks CDs are securities.
38 Minutes maintained by the SECs Fort Worth office of a February 17, 2006 meeting attended by staff from theSEC, FINRA and the Texas State Securities Board note that, [FINRA] is pursuing concerns regarding StanfordGroups advertising. The brochure used to sell its affiliates supposed CDs is unbalanced regarding the risks andbenefits. Whether or not the CDs are securities is irrelevant in terms of the advertising rules because it covers allcommunications. This occurred approximately three months before the Dallas office contacted the Sales PracticePolicy attorney to get input on the Dallas staffs assessment that they could not pursue a suitability case against theStanford firm.
Minutes maintained by the SECs Fort Worth office of a March 16, 2007 meeting attended by the SEC, FINRA andvarious state regulators notes in reference to FINRA and the Stanford firm that This matter was referred by theSEC. The firms sales materials were run through the [FINRA] advertising department and serious disclosure andadvertising deficiencies were noted. [FINRA] expects that their case will be strictly a 2210 Communications withthe Public case. The SEC is looking at the issues related to whether the firms products, which are sold as CDs, aresecurities.
39 The Stanford firm ultimately settled the advertising charge for $10,000.
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Dallas staff were also asked whether they ever considered bringing an enforcement action
under FINRA Rule 2010formerly NASD Rule 2110which allows the organization to
enforce just and equitable principles of trade at member firms. This Rule is not limited to
fraud in connection with the sale or purchase of securities, and has been used by FINRA in a
series of cases involving a variety of fraudulent conduct at member firms not involving
securities. The cause exam manager recalled considering this rule at the start of the exam, and
could not recall why it was not pursued. The Associate Director had no recollection of
considering the Rule, and expressed doubt as to whether it could serve as the basis for an
enforcement proceeding. The Dallas Director expressed the opinion that Rule 2010 was not a
stand alone rule and that FINRA can only bring 2010 enforcement actions if the member firm
has violated some other FINRA Rule. This interpretation of Rule 2010 is not substantiated by
the text of the rule, or by FINRA practices in prior enforcement actions.40
Finally, the Dallas Director, the cause examiner, and the enforcement attorney all noted
their views that, as of 2005 and 2006, they did not have sufficient indication that the Stanford
CDs were a fraudulent scheme to justify taking further action at that time. The SEC referral
letter, however, contains numerous indications of fraud in connection with the CD program
which were not investigated by the Dallas office.41 The Dallas Director did not share the SEC
40 Other FINRA employees also differed in their understanding of Rule 2010. The Regional Chief Counsel ofFINRAs New Orleans officewho serves as the enforcement attorneys supervisorindicated that FINRA takes aconservative approach to using the rule in enforcement matters. By contrast, the attorney from the Office of GeneralCounsel indicated that Rule 2010 can be used expansively. The Office of General Counsel attorney also indicated
that, when she had been employed at the SEC, SEC attorneys noted that the SEC did not have a provision likeFINRA Rule 2010. For a general discussion of Rule 2010, see page 65 of this report.
41 In particular, the letter indicates the following:
SIB [the Stanford bank] claims it is investing in foreign and U.S. investment grade bonds andsecurities, and Eurodollar and foreign currency deposits and securities from established, qualitycompanies and governmental agencies from around the world. Yet, SIBs high interest rates areinconsistent with its claimed portfolio. Minimum guaranteed interest rates since 2000 have rangedfrom approximately 3.5% to over 6% for short-term investments. For the Index-Linked CD tied tothe S&P 500, the minimum guarantee has been approximately 3.5% or a percentage of the return
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referral letter or her offices decision not to investigate the CDs with senior FINRA management
until December 2008.
The Dallas staff would have faced substantial hurdles in obtaining information from a
non-member offshore entity such as the Stanford bank. While the Spe